Aon Hewitt: Why Investors Should Keep Hedge Funds

Despite hedge funds’ disappointing performance since the financial crisis, investors should keep them in their portfolios—but only if they can invest better.

According to Aon Hewitt, some of the temporary and cyclical drags on hedge funds, such as artificially dampened volatility, are expected to lift.

Asset classes that have been highly correlated since 2008, largely due to central banks’ monetary policies, are likely to move more independently, the consulting firm said.

“This makes us more optimistic that hedge fund returns may not prove quite the disappointment they have been over the last few years,” the report said.

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Furthermore, Aon Hewitt argued hedge fund returns will look especially attractive as traditional asset classes move into a mediocre- to low-return environment with an expected rise in volatility.

These conditions are likely to push hedge funds to provide steadier returns in challenging markets and “cushion portfolios against a rising risk that equities and bonds will disappoint,” the consultant firm said.

According to the company, even with the asset class’ poor returns over the last seven years, portfolios with hedge funds generally did better in terms of risk-return than any combination of equities and bonds over the last decade.

But simply including hedge funds in the portfolio is not enough. Investors need to do better, Aon Hewitt said, as the average hedge funds “will not deliver the portfolio enhancement that we are looking for.”

Due to a wide range of returns even for funds seeming to use the same strategy, investors need to be able to pick the most skilled managers and the right funds to make hedge funds “worth it,” the firm said.

In the expected low-return environment, Aon Hewitt recommended macro strategies, particularly discretionary and systematic strategies that are not driven by wider market movements.

Aon HF Source: DataStream and Aon, data as of June 2015

Assets invested in exchange-traded funds (ETFs) will double in the next five years, Cerulli Associates has predicted.

The analytics firm projected that ETF assets will exceed $6 trillion by 2020. The asset class currently totals approximately $3 trillion.

“The slow erosion of mutual fund assets by exchange-traded products will prompt a growing number of asset managers to enter the ETF market.”“While many sponsor firms believe the ETF market will continue to grow organically, growth will largely be a result of more investors using the low-cost vehicle,” said Jennifer Muzerall, a senior analyst at Cerulli. “As new investor segments continue to acclimate to ETFs in their portfolios and sponsors develop new products, ETF assets are expected to climb as the industry enters its second decade.”

The $6 trillion figure may be even higher if enough asset managers get on board with the asset class, the firm said. According to the report, “the slow erosion of mutual fund assets by exchange-traded products will prompt a growing number of asset managers to enter the ETF market.”

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“With more asset managers developing an ETF strategy, product proliferation will continue to increase, and firms will need to think strategically about the types of products they develop, attempting to fill any white space that remains untouched,” Muzerall said.

In the last month alone, there have been fourteen new ETFs launched in the US, including offerings from BlackRock, State Street Global Advisors, and Deutsche Asset & Wealth Management, according to ETF.com. The products range from momentum-strategy ETFs to fossil fuel-free index funds.

While market cap equity ETFs are the most popular, accounting for $1.8 trillion in assets as of November, demand for strategic products like smart beta and active ETFs are growing at a fast rate, according to ETFGI.

“As investor sentiment is evolving toward solutions-oriented outcomes, sponsors need to think of ETFs no longer solely as a product, but as a tool for investors to achieve their investment objectives,” Muzerall said.